This article highlights a novel channel through which the level of deposits matters for bank fragility and efficiency. We augment a global-game model of bank runs with a consumption-saving choice that determines deposit size in the initial period. We derive two key results. First, depositors’ incentives to run increase with the amount of savings held as bank deposits. Second, a saving externality emerges because individual depositors fail to internalize the impact of their deposit decisions on the likelihood of a bank run. This leads to depositors’ over-saving and inefficient bank liquidity provision, as well as excessive bank fragility. Finally, we characterize the optimal policy to implement the efficient allocation.

We show that lender of last resort (LOLR) policy exacerbates bank interconnectedness. Using novel micro-level data, we analyze LOLR’s haircut gaps: the differences between the private market and central bank haircuts. LOLR policy incentivizes banks to increase pledging and holdings of higher haircut-gap bonds, especially those issued by domestic and systemically important banks. Effects only apply to banks, not to nonbanks without LOLR access. LOLR funding revives bank bond issuance associated with higher haircut gaps and increases the subsequent correlation between pledging and issuing banks’ bond prices, in particular during periods of low-market returns and for domestic, systemically important banks.